Money in the Economy Mmmmmmm, money!

The Money Supply M1:Currency + travelers checks + checkable deposits. M2:M1 + small time deposits + overnight repurchase agreements + overnight Eurodollars + money market mutual fund balances. M3:M2 + large denomination time deposits + term repurchase agreements + term Eurodollars + institutions only money market fund balances.

The Creators of Money The three major players whose decisions and actions determine the rate of growth in the money supply are: –The Federal Reserve (Fed) –The Commercial Banking System –The Non-Bank Public

Money Creation Banks create money in their normal, day-to- day profit seeking activities. Banks do not try to create money. Money creation occurs because we have a fractional reserve commercial banking system.

Bank Reserves Total Reserves = Required reserves plus excess reserves. –Required reserves = Deposits times reserve requirement. –Excess reserves = Total reserves minus required reserves.

Money Creation: Assumptions Assumptions: –Banks lend all their excess reserves. –The non-bank public does not use cash. –Only demand or checkable deposits exist. –The required reserve ratio is 10%.

Money Creation: Step 1 Assume the Federal Reserve injects $100 into the banking system. –Excess reserves increase by $100 in Bank #1. Banks do not face reserve requirements on injections of reserves by the Fed. Bank #1, therefore, has $100 to lend.

Money Creation: Step 2 Let Bank #1 make a $100 loan to a member of the non-bank public. –It does this by crediting the borrower’s checking account with $100. Let the borrower spend the money. Let the recipient of the money bank at Bank #2. When Bank #1 honors the check, Bank #1’s deposits and reserves fall by $100.

Money Creation: Step 3 A second bank, Bank #2, has received a new deposit of $100. –Its total reserves increase by ? Its required reserves increase by ? Its excess reserves increase by ? –Bank #2 may now make a loan of ?

Money Creation: Step 4 Bank #2 makes a loan of $90 in the form of a new demand deposit. –When the money is spent and Bank #2 honors the check, deposits and reserves at Bank #2 fall by $90. But Bank #3 now has a new deposit of $90 and may make a loan equal to ?

Money Creation: Summary New Deposit Required Reserves Excess Reserves New Loan $100 $100 $10.00 $ 90 $ 90 $ 90 $ 9.00 $ 81 $ 81 $ 81 $ 8.10 $ $ $ $ 7.29 $ $ $ $ 6.51 $ $ $1,000 $100 $900 $900

Some Simple Formulas Note that in our simple example, demand deposits are a multiple of required reserves. –Let R = required reserves –Let r = % reserve requirement –Let D = demand deposits –R = r x D orD = 1/r x R A change in deposits will be a multiple of the change in reserves.  D = 1/r x  R

The Multiplier The simple deposit expansion multiplier is 1/r or 1/reserve requirement. –r is a leakage out of the lending process. If r gets bigger, expansion of deposits gets smaller because banks have fewer excess reserves to lend. If r gets smaller, expansion of deposits gets larger because banks have more excess reserves to lend.

The real world multiplier is smaller than our 1/r because…. –Banks hold idle excess reserves and… –People hold and use cash. The real world multiplier is: The Multiplier  1 + c  r + c + e

Control of the Money Supply The Fed controls the money supply with... –Open Market Operations Purchases and sales of government securities by the Fed on the open market. –Discount Window Loans made by the Fed to banks. –Changes in the Reserve Requirement

Open Market Operations Fed Bank Presidents Federal Open Market Comm. Fed Board of Governors Securities Dealers Federal Reserve Bank of New York Commercial Banks Change in Reserves Change in Money Supply

Open Market Operations When the Fed buys Treasury bonds from a bank, it pays for the bonds by crediting the bank with an increase in reserves. When the Fed sells Treasury bonds to a bank, it accepts payment for the bonds by debiting the bank’s reserve position at the Fed.

Discount Loans When the Fed makes a discount loan to a bank, the bank is credited with an increase in reserves. When a bank repays the Fed, the bank’s reserves are debited.

Reserve Requirements If the Fed increases reserve requirements, banks have fewer excess reserves to lend, causing the expansion of deposits to decrease. If the Fed decreases or eliminates reserve requirements, banks have more excess reserves to lend, permitting the expansion of deposits to increase.

Excess Reserves and Currency Drains Banks determine the level of excess reserves. –Increases in excess reserves diminish the expansion of deposits. –Decreases in excess reserves increase the expansion of deposits.

Members of the non-bank public determine currency in circulation. –Increases in currency drains from the banking system, diminish the expansion of deposits. –Decreases in currency drains from the banking system, increase the expansion of deposits. Excess Reserves and Currency Drains

Monetary Policy I see rates rising; no, falling; no rising; no --

Monetary Policy A tool of macroeconomic policy under the control of the Federal Reserve that seeks to attain stable prices and economic growth through changes in the rate of growth of the money supply.

Central Bank Policy Channels Policy Tools Level & Growth Bank Reserves Cost & Availability of Credit Size and Growth Rate of Money Supply Market Value of Securities Volume and Growth of Borrowing and Spending by the Public Full Employment Growth Price Stability

Monetary Transmission Mechanism A monetary transmission mechanism describes the chain of events that occur in an economy as a result of a change in the rate of growth in the money supply. Good monetary policy decisions depend on understanding the different ways money can cause changes in economic activity.

Interest Rate Channel Change in Change in Change in Money Supply Interest Rates GDP Change in Exchange Rates

Monetary Policy, Interest Rates and GDP Let the Fed raise interest rates – As interest rates increase, the cost of borrowing increases, causing investment (I), consumer durables (C), and GDP to fall. Let the Fed decrease interest rates –As interest rates decrease, the cost of borrowing decreases, causing investment (I), consumer durables (C), and GDP to rise.

The exchange rate is the price of a currency expressed in terms of another currency. The exchange rate and the interest rate are positively related. –The higher domestic real rates of interest are relative to foreign real interest rates, the higher will be the foreign exchange rate for the domestic economy. Explaining Exchange Rates with Interest Rates

Interest Rate Parity Interest rate parity says that the interest rate differential between any two countries is equal to the expected rate of change in the exchange rate between those two countries.

Interest Rate Parity: Example Assume that U.S. real interest rates are higher than those in other countries. –The high rates of return on U.S. assets will attract foreign buyers, but in order to buy U.S. financial assets, foreigners must first buy dollars.

Interest Rate Parity: Example The demand for dollars increases in the global marketplace, causing the dollar to appreciate. The supply of the other currency increases in the global marketplace, causing it to depreciate.

Monetary Policy, Exchange Rates and GDP Let the Fed raise interest rates –As interest rates increase, exchange rates increase, causing net exports (X - M) and GDP to fall. GDP = C + I + G + (X - M) –As the value of the dollar increases, we export fewer goods and import more.

Let the Fed decrease interest rates –As interest rates decrease, exchange rates decrease, causing net exports (X - M) and GDP to rise. GDP = C + I + G + (X - M) –As the value of the dollar decreases, we export more goods and import fewer. Monetary Policy, Exchange Rates and GDP

Early Monetarist View A change in the money supply accompanied by no change in the velocity of money leads to an equal change in nominal GDP. Fact: Velocity is not a constant and, since the deregulation of the banking system in the 1980s, is increasingly unpredictable

Early Monetarist View: The Equation of Exchange MV = PYwhere –M = Money supply –V = Velocity of money The number of times the money supply turns over purchasing a given GDP –P = Price level –Y = Output PY = Nominal GDP

Early Monetarist View: The Equation of Exchange Given a fixed V, –If the Fed increases M, PY must increase. –If the Fed decreases M, PY must decrease. MV = PY

Monetary Transmission Mechanisms Change in the Change in Change in Change in Money Supply Interest Rates Spending GDP & Exchange Rates Keynesian: The Interest Rate Channel Monetarist: The Asset Price Channel Change in the Change in Change in Money Supply Spending GDP

Monetary Policy in the AD/AS Model

Expansionary Monetary Policy AD 1 SRAS Y P Y 1 Y 2 * Y 3 P1P1 AD 2 P2P2 Expansionary monetary policy shifts the AD curve from AD 1 to AD 2. If prices do not rise, the monetary stimulus causes Y to rise to Y 3. But as Y rise, interest rates rise, causing investment and net exports to rise by smaller amounts. As Y rises, competition for resources causes other prices to rise. Equilibrium Y occurs at Y 2 and P 2. National income rises from Y 1 to Y 2. Prices rise from P 1 to P 2. 0 LRAS

Contractionary Monetary Policy AD 2 SRAS Y P Y 3 Y 2 Y 1 P2P2 AD 1 P1P1 0 Contractionary monetary policy shifts the AD curve from AD 1. to AD 2 If prices do not fall, the monetary contraction causes Y to fall to Y 3. But as Y falls interest rates fall, causing investment and net exports to fall by smaller amounts. As Y falls, less competition for resources causes other prices to fall. Equilibrium Y occurs at Y 2 and P 2. National income falls from Y 1 to Y 2. Prices fall from P 1 to P 2. LRAS